Report: Private Student Loan Underwriting Likely Blocks Out Low-Income Students
By Allie Bidwell, Communications Staff
Private student loans tend to carry a certain stigma in higher education. They typically have higher interest rates, there are fewer income-based protections and less flexible repayment options, and many require the student borrower to have a co-signer. But a new paper from the American Enterprise Institute argues the private student loan market should be expanded as a way to help lower income students who may be boxed out – so long as the underwriting methods for doling out the money are changed.
Private student loans currently make up about 9 percent of the multi-billion dollar overall student loan market, but low-income students are less likely to take out private loans, even when they face similar net prices as their higher-income peers, the paper found.
One contributing factor, according to authors Andrew Kelly and Kevin James, could be the criteria private lenders use to make loans to individuals. Typically, private lenders use “backward-looking” criteria, such as credit scores, to determine eligibility. The problem, Kelly and James argue, is that many low-income students have little or no credit history, and likely do not have access to a creditworthy co-signer. In fact, nearly 70 million Americans do not have a credit score or have a credit history too thin to apply traditional scoring methods, the paper said.
Rather than looking backwards, the paper said, private lenders should explore ways to incorporate more “forward-looking” criteria – such as program price, program quality, and estimated future earnings – to determine eligibility. That is, private lending could be more outcomes-based, and focused on a student’s potential, rather than his or her past – or that of his or her parents.
“A lender who was able to predict those outcomes could expand their pool of borrowers to include individuals who are currently underserved,” Kelly and James wrote. “But the outcome for any given student is uncertain, making it a risky bet for lenders. Meanwhile, lending on the basis of past credit history carries far less risk but excludes many who would benefit from the pool.”
But making a change to more alternative methods of underwriting gets into murky waters with regard to federal regulations.
The fair lending requirements of the federal Equal Credit Opportunity Act (ECOA), for example, prohibit lenders from discriminating against potential borrowers based on protected characteristics, such as race, religion, sex, or age, among other characteristics. And although lenders might not intentionally discriminate based on those characteristics, some lending decisions might have that effect on a protected class, according to the paper. The Consumer Financial Protection Bureau, for example, raised concern with the use of institutional cohort default rates in underwriting because racial and ethnic minority students are more concentrated in schools with higher default rates.
In order to make way for the use of more alternative lending practices in the private student loan market, Kelly and James made several recommendations for policymakers. They suggested that policymakers clarify fair lending laws’ impact on these nontraditional models, that they make more program-level and institutional performance data publicly available, and that they cap federal PLUS loans to make more space for “alternative and forward-looking private-sector options.”
“The emerging revolution in consumer finance, in which startups are moving beyond credit scores to use new measures of creditworthiness, could reshape private student lending,” Kelly and James wrote. “Under the status quo, many students who could benefit from additional financing likely lose out, and the system muddles along with lots of credit but little accountability. In contrast, a private finance market built around a broader set of underwriting criteria has the potential to expand opportunity while strengthening market discipline in the sector.”
Publication Date: 6/2/2016
David S | 6/2/2016 1:13:08 PM
I'm glad to see this trend emerging, because the whole point for many students is that earning the degree will help them out of the financial circumstances that they have found themselves in. But it's still in its infancy. I've seen one "forward-looking" loan that's only available to international students, and two that are only for students attending code-writing bootcamps and similar focused training within and by specific industries rather than actual postsecondary education, so this still has a ways to go.
But even if/when this approach spreads to traditional IHE's, there's the threat of red-lining. I remember when some FFELP lenders stopped lending to CC students, which was backdoor discrimination. Private loans are less regulated, and we do run the risk of seeing innovations only being available to those at elite schools, where students tend to already have more advantages.
Joseph K | 6/2/2016 12:18:21 PM
It would be ideal if outcome based decision making was employed regarding both borrowing and lending. Not only should lenders consider future earnings, but borrowers should self examine as well. Common sense would suggest borrowers should take on less debt if their median entry level wage expectations are lower for their chosen field. And entering the workforce with less debt is positive for everyone, regardless of their financial history or potential future earnings.
Joseph K | 6/2/2016 12:1:18 PM
Here is a link to the paper, in case anyone wants to read the whole thing:
http://www.aei.org/wp-content/uploads/2016/05/Looking-Backward-or-Looking-Forward.pdf
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